A History of the Federal Reserve, Volume 2 (83 page)

AN EXPANDING ECONOMY

Expectations improved as the recovery accelerated. In September, the FAC told the Board that it anticipated continued moderate expansion, but the FAC members expressed concern about congressional resistance to the tax cut and the balance of payments as factors weakening the outlook. By November these concerns received less attention; the FAC described the outlook as very positive (Board Minutes, September 17 and November 19, 1963).

The facts support the change of outlook. Growth of real GDP reached 7.2 percent in the third quarter and was above President Kennedy’s goal of 5 percent for the four quarters of 1963. Unit labor costs declined, and inflation remained moderate. Treasury forecasts for 1964 became more optimistic. At the BIS and OECD meetings, discussion centered on Italian and Dutch wage increases and concerns about European inflation. For the first time since consultation began at the OECD, “the U.S. balance of payment difficulties were not on the agenda” (FOMC Minutes, November 12, 1963, 10–11). The Europeans recognized that inflation abroad had improved the U.S. position. One report suggested that “the Europeans thought the United States was moving in the right direction . . . and that the crisis might have been passed” (ibid., 14). Chairman Martin, urging an unchanged policy, expressed concern about the start of inflation but optimism about the outlook. “Everything was going in the Committee’s favor” (ibid., 59).
²⁶⁶

Assassination of President Kennedy at 1:30 PM eastern standard time on November 22 caused a surge of uncertainty that temporarily altered expectations. Prices on the New York Stock Exchange fell sharply on volume of 2 million shares in a half hour. Trading on the foreign exchange market in New York halted; trading in Europe had ended for the week. To show the intent to stabilize, at 2 o’clock Coombs offered German marks, British pounds, and Netherland guilders at exchange rates that prevailed before the assassination. The FOMC gave immediate approval to increase the swap agreement with Switzerland to $300 million.
²⁶⁷

266. The FOMC remained divided, but only Mills dissented from the directive. Robertson’s statement showed his unhappiness with vague directives. He voted for the directive out of agreement with language; “he expressed some doubt, however, that the directive would be construed consistently with his thinking” (FOMC Minutes, November 12, 1963, 62).

267. Coombs reported that his interventions were successful. “We have subsequently received numerous messages from both the market and foreign central banks that our intervention on Friday afternoon helped considerably to confirm market expectations that the central banks would jointly and firmly resist any speculative developments” (telegram, Coombs to Board of Governors, Board Records, November 23, 1963, 3). This seems an overstated claim. Coombs reports his total intervention in all currencies that afternoon as $23.5 million, mainly in pounds and marks (ibid., 3). At the time, banks reported $2.6 billion of short-term liabilities to foreigners (Board of Governors, 1976, 937). Coombs explained the success of these small operations: “In those days official assurances enjoyed a full measure of credibility”
(Coombs, 1976, 104–5). At 2:08, his offer to sell pounds and, a few minutes later, guilders found no buyers. Further, the following day London reported that it supplied dollars instead of buying dollars to support the exchange rate (telegram, Coombs to Board of Governors, Board Records, November 23, 1963, 4). The Soviet Union sold gold on the London market at $35.10 (ibid., 6).

Heightened uncertainty did not last. Vice President Lyndon B. Johnson became president and made reassuring statements to calm the public. At his first meeting with his economic advisers, Walter Heller warned him that, without the tax cut, the economy could slow or even decline in the second half of 1964. There was no need to point out that this would occur during the election (Bernstein, 1996, 31). Johnson explained that he favored the tax cut and would make it a top priority.

When the FOMC held a telephone conference on Tuesday morning, reports gave no suggestion of market crisis or anxiety. The stock market had started to recover, and currency markets were quiet. The FOMC renewed its directive but inserted “cushioning any unsettlement that might arise in money markets stemming from the death of President Kennedy” (FOMC Minutes, November 26, 1963, 6). At the next FOMC meeting, the staff noted markets’ rapid return to normal (FOMC Minutes, December 3, 1963, 13–14). The FOMC retained the clause about Kennedy’s death until December 17.
²⁶⁸

The staff noted in early December that the money stock had increased by $1 billion in each of the past two months, an annual rate of more than 6 percent. Hayes noted a shift of credit expansion into new loans instead of government securities. Martin’s concern was excessive exuberance caused by belief that Congress would pass the tax cut. He suggested increasing discount rates even if the Treasury was borrowing. The FOMC took no action.

Russian gold sales had offset U.S. gold sales to France, Argentina, and Austria, so the gold stock had not changed for eighteen weeks. By mid-month Russian gold sales slowed, and the gold stock resumed its decline.
²⁶⁹

For the first time since the early 1930s, the Federal Reserve had to carefully watch the gold reserve ratios at the individual reserve banks. The cause
was a seasonal increase in currency and deposits during the Christmas season. The Board’s first response was to consider assessing a mandatory penalty on reserve banks with deficiencies (Board Minutes, November 29 and December 2, 1963).
²⁷⁰
One of the principal arguments against was reluctance to show reserve deficiencies in the Annual Report.

268. At the December 17 meeting, Dewey Daane joined the FOMC. Daane became a governor on November 29, 1963, replacing George H. King, Jr., who resigned on September 18 for health reasons. Immediately prior to his appointment, Daane had served in the Treasury as deputy to Robert Roosa.

269. The December 3 meeting reopened discussion of releasing the minutes to scholars. Members divided into three groups. Martin and three others favored release after a lag of several years. Martin argued for improved understanding of their decisions. Seven favored a limited release with restrictions; several wanted to limit access to an official historian. Hayes and two others opposed. Hayes, following the tradition of central bankers, said, “The FOMC’s deliberations aren’t a matter of public concern” (FOMC Minutes, December 3, 1963). He suggested that Martin had responded to political pressure, an issue between New York and Washington dating back to the founding.

After meeting with the bank presidents, the FOMC again changed the method of allocating securities. Each week the System shifted securities and gold through the Interdistrict Settlement Fund to equalize the reserve ratios based on the most recent five days of data. During the week, the manager made special adjustments to remove reserve deficiencies. The overall System ratio was about 30 percent, five percentage points above the overall requirement. In March 1965, Congress removed the 25 percent reserve requirement against bank reserves, a step toward ending the gold reserve requirement entirely three years later. Chairman Martin defended the 1965 change as a way of releasing $4.8 billion from earmarked to free gold.

By early 1964 the mood had changed. The Economic Report of the President described as unparalleled the dollar rise in real GNP and labor incomes since the recession ended. Inflation remained low and the balance of payments “is improving . . . sharply in response to measures begun in 1961 and reinforced last July” (Council of Economic Advisers, 1964, 11). The report urged tax rate reduction accompanied by “monetary and debt policy . . . directed toward maintaining interest rates and credit conditions that encourage private investment” (ibid., 11). In the report and elsewhere at the time, President Johnson declared the beginning of the War on Poverty.

The view at the Federal Reserve was more wary. It too noted the smaller payments deficit ($3 billion) and smaller gold sales in 1963. Coombs pointed out, however, that Soviet gold sales reached $500 million in 1963, $300 million more than expected
²⁷¹
(FOMC Minutes, January 7, 1964, 6–7). He anticipated continued heavy Soviet sales in 1964. Soviet sales allowed the gold pool to satisfy market demand without calling on the United States.
Hayes remarked that a large part of the improvement in payments position resulted from one-time changes such as repayments of postwar loans and purchases of military equipment. Balderston gave credit to the interest equalization tax and worried that the improvement would end. The staff responded that their projected improvement depended very little on the tax (FOMC Minutes, January 28, 1964, 17–18). Several others commented on interest rate increases abroad. Foreign central banks raised interest rates to support currency parities instead of removing capital controls.

270. The penalty reflected provisions in the original Federal Reserve Act, intended to keep individual reserve banks from extending excessive credit. This kind of autonomy was no longer relevant. Reserve bank expansion depended mainly on its participation in the open market account. Governor Robertson recognized this when he referred to the problem as “bookkeeping” (Board Minutes, November 29, 1963, 3).

271. Hayes reported on the recent BIS meeting in Basel. He described a “general feeling of unease” about the euro-dollar market but no full consensus about what to do (FOMC Minutes, January 28, 1964, 7–8). Many Europeans now favored a multiple reserve currency system to reduce dependence on the dollar. On February 13, 1964, the United States drew $125 million in foreign currencies from the IMF. Foreign central banks sold dollars to the IMF, pushing IMF dollar holdings toward the permitted maximum, 75 percent of the U.S. quota. The U.S. also redeemed the excess dollars.

Following the July increase in ceiling rates for time deposits, commercial bank time deposits increased rapidly, so bank credit expanded much more than money (M 1 ). Since the Treasury was in the market, the FOMC took no action in January.

The
Directive
Again

Both Mills and Robertson objected that an unchanged directive did not mean that policy had not changed. Both objected that current actions pegged interest rates or the term structure. Robertson added: “Dealer statistics suggest a concentration of private investor sales at times when official accounts are large buyers, with a corresponding thinning out of private selling activity in adjacent periods. Dealers . . . speak of the tendency for prospective sellers . . . preferring . . . to unload on some future official buying orders” (FOMC Minutes, January 28, 1964, 29).
²⁷²

272. The staff produced a report on intervention in the long-term market by the Federal Reserve and the Treasury. It showed that, except for over-t
en-year maturities where volume was small, combined Federal Reserve and Treasury purchases were generally less than 10 percent of dealer purchases.

The problem for the FOMC was that the more control the System exercised over interest rates, the less information interest rates contained about the market’s position. “Instead of the market being a window through which we can observe indications of private actions that might call for policy changes, we have made it—in part at least—a mirror of our own intentions with respect to rates” (ibid., 30). Robertson and Mills urged the FOMC to let market rates fluctuate more freely. Mills urged a return to the bills-only procedures.

Soon after these comments, the Board’s secretariat reconsidered the content of the directive and the instructions to the manager. The discussion continued for the rest of the year. The secretariat distinguished between two broad measures—fi rst, money market conditions and, second, monetary or credit aggregates. It then made a very odd distinction. The “first group are of concern to the Committee on two counts: they affect international capital flows, and they are read by the market and the public as ‘signals’ of current monetary policy.” As to the aggregates, their influence was on the domestic economy
²⁷³
(quoted in memo F. W. Schiff to Alan Holmes, Board Records, FOMC: General, March 27, 1964, 102).

The FOMC’s problems of instructing the manager and directing policy action surfaced again in February. The manager reported that his instructions had proved inconsistent, so he had chosen to ignore the free reserve target. He now gave more attention to the Federal funds rate and less to the Treasury bill rate. He had developed “new contacts that disclosed what was happening with respect to the volume of flows behind the relatively fixed Federal funds rate.”

Mitchell was incensed. “Such information may be very useful to the Desk, but the problem remained of how the desk could tell
what
objectives
the
Committee
wanted
it
to
pursue”
(FOMC Minutes, February 11, 1964, 15–16; emphasis added). Soon after, he joined with two presidents to express dissatisfaction with the form and content of the dir
ective. It was, they said, “too incomplete to cover the policy decisions, . . . internally inconsistent, . . . [and] too vague to establish Committee authority over . . . the Manager” (draft memo to FOMC from Ellis, Mitchell, and Swan, Board Records, June 2, 1964, 1). They recommended quantitative terms and more specific language whenever possible.
²⁷⁴
Their proposed directive had four
parts that gave a quantitative and qualitative description of the current economic position, “an analytic statement of recent credit and monetary developments,” and “appraisal of the current economic and financial scene” and “the longer run policy intent,” and a range for free reserves for the next three weeks (ibid., 3–6). The choice would be conditional on the level or range of interest rates that the market determined. The group proposed use of annual rates of increase of reserves required to support private demand deposits as the indicator of the FOMC’s “longer run policy intent” (ibid., 4). This measure excluded Treasury deposits from total demand deposits.

273. “It seems safe to surmise that with respect to the condition of the
domestic
economy, variables in the second group are of more fundamental concern to the Committee than those in the first” (quoted in memo F. W. Schiff to Alan Holmes, Board Records, FOMC: General, March 27, 1964, 1–2). The memo does not offer an explanation. It is an error.

274. In May 1964, in a report to the House Banking and Currency Committee, Karl Brunner and I criticized the Federal Reserve on similar grounds. We knew nothing about the
internal discussion and relied only on published material and interviews with officials who did not mention it. We showed that free reserves had little relation to monetary aggregates or to output and prices, that the directive was so vague that the manager made many of the decisions, that he often moved ahead of the FOMC, that policy had a procyclical bias, and that longer-term objectives had little if any influence on decisions or actions. We recognized that precise knowledge was not available but criticized the absence of systematic research on these basic issues. Discussion of the Ellis, Mitchell, and Swan memo refers to “critics,” suggesting our criticism may have encouraged consideration of procedures (Brunner and Meltzer, 1964). Our study also criticized the absence of research on linkage between policy actions and goals and on the transmission process. The memo refers to some of these criticisms without making specific reference.